Fed's Full Normalization

The US Federal Reserve has been universally lauded for the apparent success
of its extreme monetary policy of recent years. With key world stock markets
near record highs, traders universally love the Fed's zero-interest-rate and
quantitative-easing campaigns. But this celebration is terribly premature.
The full impact of these wildly-unprecedented policies won't become apparent
until they are fully normalized.

Back in late 2008, the US stock markets suffered their first full-blown panic in
101 years. Technically a panic is a 20% stock-market selloff in a couple
weeks, far faster than the normal bear-market pace. In just 10 trading days
climaxing in early October 2008, the US's flagship S&P 500 stock index
plummeted a gut-wrenching 25.9%! It felt apocalyptic, the most extreme stock-market
event we'll witness in our lifetimes.

This once-in-a-century fear superstorm terrified the Fed's elite policymakers
on its Federal Open Market Committee. As economists, they are well aware of
the stock markets' powerful wealth effect. With equities cratering,
Americans could dramatically slash their spending in response to that devastating
loss of wealth and the crippling fear it spawned. And that could very well
snowball into a full-blown depression.

Consumer spending drives over two-thirds of all US economic activity,
it is far beyond critical. So the Fed felt compelled to do something. But like
all central banks, it really only has two powers. It can either print money,
or talk about printing money. The legendary newsletter guru Franklin Sanders
humorously labels these "liquidity and blarney". With stock markets burning
down in late 2008, the Fed panicked too.

Led by uber-inflationist Ben Bernanke, the Fed embarked on the most extreme
money printing of its entire 95-year history to that point. The FOMC cut its
benchmark Federal Funds Rate by 50 basis points at an emergency unscheduled
meeting on October 8th. It lopped off another 50bp a few weeks later on October
29th. And then on December 16th, it slashed away the remaining 100bp to take
the FFR to zero.

The federal-funds market is where banks trade their own capital held at the
Fed overnight. It's that supply and demand that determines the actual FFR,
so the Fed can't set it directly by decree. Instead the Fed defines an FFR
target, and then uses open-market operations to boost funds supplies enough
to force the FFR down near its target. The Fed creates new money out of thin
air to oversupply that market.

When central banks force their benchmark rates to zero through money printing,
economists call it a zero-interest-rate policy. Once ZIRP is implemented,
a central bank's conventional monetary-policy tools are exhausted. Once zero-bound,
central banks can't really manipulate short-term interest rates any lower.
So they continue printing money, but use it to purchase bonds to force long-term
interest rates lower as well.

Historically this was called monetizing debt, and was only seen in
small countries that were economic basket cases. Expanding the money supply
so rapidly to buy government bonds naturally led to ruinous inflation. But
today this exact-same practice is euphemistically known as quantitative
easing. QE is truly the last resort of central banks once they succumb
to ZIRP, the treacherous final frontier of money printing.

The Fed formally launched QE for the first time ever on November 25th, 2008.
That was several weeks before ZIRP was born. Because of intense political opposition
to direct monetization of US government debt, the Fed initially started with
mortgage-backed bonds. But what later became known as QE1 was expanded to include
US Treasuries in mid-March 2009. This marked a watershed event in Fed history.

By conjuring money out of thin air to buy up US Treasuries, the Fed was directly
subsidizing the Obama Administration's record
deficit spending. As it purchased Treasuries and transferred brand-new
dollars to Washington, the federal government spent this money almost immediately.
That injected this vast new monetary inflation directly into the underlying
US economy, creating tremendous market distortions.

Nowhere was this more pronounced than in the US stock markets. As the Fed
expanded the money supply to buy bonds, its holdings rapidly accumulated which
ballooned its balance sheet dramatically. Even though this new inflation was
flowing into the bond markets, it had a dramatic impact on the stock markets.
Since mid-2009, the S&P 500's powerful bull market has perfectly
mirrored the Fed's balance sheet!

Whenever one of the Fed's three QE campaigns was in full swing, the stock
markets rose in lockstep with bond purchases. But whenever the Fed's debt monetizations
slowed or stopped, the stock markets consolidated or corrected. This tight
relationship between stock-market levels and the Fed's balance sheet is incredibly
important for investors and speculators to understand, as it has serious implications.

In the coming years, the Fed is going to have to normalize both ZIRP and QE.
If the Fed drags its feet too long, the global bond markets will force it to
act. Normalizing ZIRP means dramatically hiking the Federal Funds Rate, and
normalizing QE means selling trillions of dollars of bonds. And only after
both interest rates and the Fed's balance sheet return to normal levels will
ZIRP's and QE's impact become apparent.

Today's euphoric and complacent stock traders assume that the first measly
quarter-point rate hike will end ZIRP, and that QE concluded in late October
2014 when the FOMC ended its QE3 campaign. But nothing could be farther from
the truth! We are only at half-time for the most extreme experiment
in US monetary policy in the Fed's entire history. The fat lady won't have
sung until ZIRP and QE are fully unwound.

This full normalization is epic in scope, and will take the Fed years to accomplish.
Stock traders don't appreciate how extremely anomalous both interest rates
and the Fed's balance sheet are today. This chart reveals the scary truth.
It looks at the Federal Funds Rate and yields on 1-year and 10-year US Treasuries
over the past 35 years or so. And the Fed's balance sheet since it was first
published in 1991.

The inflection points in interest rates and money supplies driven by the advent
of ZIRP and QE are just massive beyond belief. Short rates totally collapsed
near zero, and the Fed's balance sheet skyrocketed into the stratosphere.
The most extreme monetary policies in US history aren't going to normalize
easily. And this process is going to cause great financial pain as stock and
bond markets are forced to mean revert lower.

Through its overnight Federal Funds Rate, the Fed utterly dominates the short
end of the yield curve. Note above how yields on 1-year US Treasuries track
the FFR nearly flawlessly. So just like during past Fed rate-hike cycles, the
rising FFR is going to push up the entire spectrum of short-term interest rates.
And this normalization process will require a long series of rate hikes,
not just today's popular "one and done" fantasy.

The very word normalization denotes something manipulated away from
norms returning back to those very norms. So defining "normal" FFR levels is
important to get an idea of how high the Fed is going to have to hike. Since
late 2008's stock panic scared the Fed into going full-on ZIRP for the first
time ever, everything since is definitely not normal. Nor were the super-high
rates of the early 1980s, the opposite extreme.

But between those two FFR anomalies was a 25-year window running from 1983
to 2007. This quarter-century span is the best measure of normal we can get
in modern history. It encompasses all kinds of economic and stock-market conditions,
including multiple severe crises. Throughout all of it, the Federal Funds Rate averaged
5.5% on a weekly basis. That is normal, where the Fed will eventually have
to return.

While today's hyper-complacent stock traders are fixated on the Fed's first
rate hike in 9 years, that's only 25 basis points. The Fed needs to do a full
550bp of hikes! At a mere quarter-point at a time, a full normalization would
take 22 hikes! And that's probably how it will play out, as the Fed
is too scared of roiling stock traders to hike faster. The last Fed rate hike
exceeding 25bp happened way back in May 2000.

The Fed's policy-deciding Federal Open Market Committee meets 8 times a year,
and only raises rates at those scheduled meetings to minimize the risk of shocking
the markets. So the 22 quarter-point rate hikes required for full normalization
would take nearly 3 years without any interruptions! That's an awfully-long
time for higher rates and the resulting bearish psychology to weigh heavily
on lofty stock markets.

Despite the one-and-done hopes of stock traders today, it's really risky for
the Fed to start and stop rate hikes in an erratic fashion. The more unpredictable
any tightening cycle is, the more damage it will do to stock-market sentiment.
So this coming rate-hike cycle is likely to play out like the last one between
June 2004 to June 2006. Over that 2-year span the Fed hiked 17 times more
than quintupling the FFR to 5.25%!

While slashing the FFR to zero manipulated the short end of the yield curve,
the Fed's utterly-monstrous purchases of US Treasuries actively manipulated the
long end. The FOMC was very open about this mission, including a sentence about
QE in its meeting statements that read "these actions should maintain downward
pressure on longer-term interest rates". Excess bond demand forces long rates
lower.

Since the dawn of the ZIRP and QE era in early 2009, the yield on benchmark
US 10-year Treasuries has averaged just 2.6%. This rate is exceedingly important
to US economic activity, as it determines the pricing of mortgages. Artificially-low
long rates have led to artificially-low mortgage rates, which fueled a boom
in housing-related activity just as the Fed intended. A full normalization will
totally wipe this out.

In that quarter-century span between the early 1980s rate spikes and the 2008
stock panic's introduction of ZIRP, yields on 10-year Treasuries averaged 6.9%.
That is fully 2.6x higher than today's manipulated levels! As the Fed
normalizes its balance sheet by letting its QE-purchased bonds mature and roll
off, long rates will absolutely return to normal levels. And the market and
economic impacts will be adverse and vast.

In mid-June, 30-year fixed-rate mortgage pricing climbed back over 4.0% as
10-year Treasury yields regained 2.4%. That's a 1.6% premium over what the
US government can borrow for. So when 10-year Treasury yields are fully normalized
in the coming years, 30-year mortgage rates will likely soar to at least 8.5%!
That's certainly not unprecedented, these rates averaged 8.1% throughout the
entire 1990s.

That wealth effect the Fed fears slowing consumer spending applies to housing
prices even more so than stock-market levels, since far more Americans have
most of their wealth in houses than in stocks. Mortgage prices more than
doubling would have a drastic impact on house prices, since people could
only afford to borrow much less. So the debt-fueled real-estate boom is going
to collapse as rates normalize.

Bond prices will crater too. Regardless of the yields bonds were originally
issued at, they're bought and sold in the marketplace until their coupon yields equal
prevailing rate levels. So traders will dump bonds aggressively as rates
mean revert higher, leading to steep losses in principal for the great majority
of bonds that are not held to maturity. And the Fed's selling as it normalizes
its balance sheet will exacerbate this.

As the chart above shows, the Fed's balance sheet naturally rises over time
as this central bank inflates the supply of US dollars. But its pre-QE trajectory
was well-defined and relatively mild. Once the Fed reached ZIRP and could cut
no more, it launched QE which led to a balance-sheet explosion. This
too will have to mean revert dramatically lower in the Fed's full normalization,
with terrifying bond-market implications.

In the first 8 months of 2008 before that once-in-a-century stock panic, the
Fed's balance sheet was averaging $849b. At its recent peak level in mid-February
2015, all those years of QE bond buying had mushroomed it to $4474b! That's a
5.3x increase in just 6.5 years. The great majority of that has to be unwound,
or that vast deluge of new dollars will eventually lead to massive and devastating
inflation.

If the normal trajectory of the Fed's balance sheet before the stock panic
is extended to today, it suggests a normal balance-sheet level of around $1100b.
To return to there from today's incredibly-high QE-bloated levels would require
a staggering $3329b of bond selling from the Fed! Even though it will
take years for this to unfold, $3.3t of central-bank bond selling will force
bond prices much lower. And thus rates higher!

Higher rates won't just decimate the bond markets, but also wreak havoc in
today's super-overvalued and radically-overextended stock
markets. Higher rates hit stocks on multiple fronts. They make shifting capital
out of stocks into higher-yielding bonds more attractive, leading to capital
outflows from the stock markets. The higher debt-servicing expenses also directly
erode corporate profits, leaving stocks more overvalued.

But today's main stock-market threat from rising rates is their impact
on corporate buybacks. These are the primary reason why the S&P 500
level so
perfectly mirrored the ballooning Fed balance sheet of recent years.
American companies took advantage of the artificially-low interest rates
to borrow vast sums of money not to invest in growing their businesses, but
to use to buy back and manipulate their stock prices.

Last year for example, stock repurchases by the elite S&P 500 companies
ran a staggering $553b! That was their highest level since the last cyclical
bull market was peaking in 2007. Since these buybacks are largely financed
by cheap money courtesy of ZIRP and QE, the Fed's normalization is going to
just garrote buybacks. And they are the overwhelmingly-dominant source of capital
chasing these lofty stock markets.

So the massive coming normalization of interest rates and the Fed's bond holdings are
very bearish for stocks as well as bonds. That's one reason why traders
are so pathologically fixated on the next rate-hike cycle. The smart ones
know full well that it will end this Fed-conjured market fiction and lead
to enormous mean reversions lower in both stock and bond prices. Full normalization
will spawn a bear market.

Ironically the asset class that will benefit most from rate hikes is the one
traders least expect, gold. The conventional wisdom today believes gold
is going to get wrecked by rising rates since it has no yield. But just
the opposite has proven true historically! Gold is an alternative asset,
and demand for these critical portfolio diversifiers soars when conventional
stocks and bonds are struggling. Like during rate hikes.

During the Fed's last rate-hike cycle between June 2004 and June 2006 where
the Federal Funds Rate was more than quintupled to 5.25%, gold actually
soared 50% higher! And in the 1970s when the Fed catapulted its FFR from 3.5%
in early 1971 to a crazy 20.0% by early 1980, gold skyrocketed an astounding 24.3x
higher! Higher rates really hurt stocks and bonds, rekindling investment
demand for alternatives.

The Fed's inevitable coming full normalization of ZIRP and QE is going to
be vastly more impactful than traders today appreciate. When interest rates
rise and the Fed's bond holdings fall, there's no way that stock and bond prices
are going to remain anywhere near today's lofty artificial central-bank-goosed
levels. The full normalization is going to greatly alter the global investing
landscape, creating a minefield.

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The bottom line is the Fed's post-stock-panic policies have been extreme beyond
belief. They have led to epic distortions in the global markets. These markets
are going to force the Fed to fully normalize the wildly-anomalous conditions
it created with ZIRP and QE. And with interest rates and the Fed's balance
sheet at such extreme levels today, the coming normalization will be very treacherous
and take years to unfold.

Today's euphoric stock traders believe ZIRP and QE have been huge successes,
but the jury is still out until they've run their courses and been fully unwound.
The most-extreme monetary experiment by far in US history is just at half-time
now, the fat lady hasn't even taken the stage. The full normalization of ZIRP
and QE is likely to be as negative for stock and bond prices as its ramping
up proved positive for them.

If you have questions I would be more than happy to address
them through my private consulting business. Please visit www.zealllc.com/financial.htm for
more information.

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Due to my staggering and perpetually increasing e-mail load, I regret that
I am not able to respond to comments personally. I WILL read all messages though,
and really appreciate your feedback!

Mr. Hamilton, a private investor and contrarian analyst,
publishes Zeal Intelligence, an in-depth monthly strategic and tactical analysis
of markets, geopolitics, economics, finance, and investing delivered from an
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